Plotting year-end ways to shrink your 1998 income tax bill may not be anyone's idea of holiday season merriment.
But this season, year-end tax planning will prove critical for many individuals as a result of the valuable new tax breaks that made their debut this year, some additional tax breaks that are set to take effect New Year's Day and the possibility of even more major tax cuts from the next Congress.Between now and New Year's Eve, there are many things individuals can do to ensure they qualify for the new tax breaks, pick up hundreds or thousands of dollars in extra deductions, defer taxable income, minimize the tax bite on investment sales and position themselves to take maximum advantage of any tax cuts Congress might enact next year.
In many cases, the tax savings will be enough to finance a lot of Hanukkah and Christmas shopping and keep the party going New Year's Eve.
Indeed, there is much at stake for millions of taxpayers just as a result of the new tax breaks created by the Taxpayer Relief Act of 1997. New this year is a family tax credit of up to $400 per child under age 17; a $1,500 Hope Scholarship credit for the first two years of college; a $1,000 Lifetime Learning credit; and a deduction for up to $1,000 in student loan interest. The new Roth IRA offers the potential for many thousands of dollars in tax savings.
For many middle- and upper-income taxpayers, how much, if any, of the new breaks they'll be able to claim could hinge on what actions they take in the remaining weeks of the year. Most of the new breaks are available only to taxpayers with incomes below specified levels.
General strategy
For most people, the best course is the traditional year-end strategy for minimizing tax bills -- prepay some of next year's deductible expenses and defer income, where possible, until next year. The strategy could help many of those bordering on the income-eligibility limits for the new law breaks get What's more, there is the possibility that the income you defer will be taxed at a lower rate if the Republican majority in Congress succeeds in pushing through another tax cut next year.
"I think it's highly likely we'll get a tax bill next year," said Thomas Ochsenschlager, a Washington, D.C. tax partner at the accounting firm of Grant Thornton.
Many Republicans want to cut capital gains rates again and provide tax relief for working married couples. Some Republicans are also pushing for an across-the-board cut in income tax rates.
Some new breaks are already set to take effect at the stroke of midnight New Year's Eve as a result of the 1997 tax act and more recent legislation passed by the 105th Congress. Among them are more liberal eligibility requirements for home-office deductions and a bigger health insurance deduction for the self-employed. Making the most of the pending changes will require some special year-end strategies. For example, the home-office change will provide incentive for those affected to delay paying certain household expenses until next year when they're first able to make use of the home-office deduction.
New breaks
For many middle and upper-middle income taxpayers, the focus of year-end tax planning will be to meet the income-eligibility requirements for the new law breaks that became available this year.
The new breaks have varying income requirements. For instance, the tuition credits are reduced for couples with "adjusted gross incomes" above $80,000 on a joint return and are completely unavailable for couples with adjusted incomes above $100,000. For single filers, the credits are phased out for incomes between $40,000 and $50,000.
The student loan deduction begins to phase out for incomes above $60,000 on a joint return ($40,000 for singles). The family tax credit starts to phase out for joint incomes above $110,000 ($75,000 for singles).
Eligibility to contribute to Roth IRAs and the new education IRAs starts to phase out for joint incomes above $150,000 ($95,000 for singles). And whether you're married or single, the right to convert regular IRAs into the new Roth IRAs is available only if your adjusted income is under $100,000.
If you're bordering on the income limits for one of the tax breaks, there are some steps you can take between now and the end of the year that may help lower your income enough to make you partly or fully eligible for the tax benefit.
Employees can arrange with their employer to defer payment of year-end bonuses until after Dec. 31. Self-employed individuals can delay sending out bills so that customer payments won't arrive until next year. Retirees can hold off making withdrawals from retirement accounts. And investors can wait until next year to cash in their profits and take losses this year.
Time deductible expenses
Paying certain deductible expenses by Dec. 31 will also help.
There are several types of deductions that will reduce your adjusted gross income. They include business expenses incurred by self-employed individuals and rental property owners; job-related moving expenses; deductible retirement account contributions; alimony payments; and health-insurance premiums paid by eligible self-employed individuals.
The new student loan interest deduction will also reduce adjusted gross income, but not for purposes of determining eligibility for the student loan deduction itself.
Most other types of deductions, such as charitable contributions and other itemized deductions, won't affect your adjusted gross income -- the figure that will largely determine your income-eligibility for the tax benefit. (Adjusted gross income is computed on tax forms before itemized deductions enter into the tax calculations.)
Stay below the limits
If your adjusted gross income is projected to be below the income-eligibility limits for a tax break, watch what financial moves you make between now and the end of the year to insure you don't inadvertently end up above the income limits.
For example, before making a big year-end sale of investments or a large retirement account withdrawal, be sure to calculate the impact on your eligibility for the income-contingent tax breaks.
Also be cautious about making a large purchase of mutual fund shares between now and the time the fund makes its year-end capital gains distribution. If you buy before the distribution, you'll have to report the distribution as income on your tax return.
Plan for next year
If your income is expected to be well above the eligibility limits this year, see if there is anything you can do in the remaining weeks of the year to help you meet the income-eligibility requirements next year.
For example, consider accelerating income into this year, such as by selling an investment early. That may help reduce your income enough next year to qualify for the tax breaks.
"You may have to play one year against the other," said David Rhine, national director of family wealth planning at the accounting firm of BDO Seidman in New York. "If I see no way I'm going to be eligible this year, maybe I can do something to help next year."
Another step you can take now to reduce your income next year by thousands of dollars is to sign up for your employer's 401(k) retirement plan and tax-sheltered "flexible spending accounts" (FSA) for paying dependent-care and out-of-pocket medical bills.
This is the time of year when most companies open enrollment for these employee benefit plans for the coming year.
Salary earmarked to a 401(k) or FSA will reduce your adjusted gross income.
College expenses
If you're eligible for one of the new breaks for college expenses, check to see if you'll be eligible for the maximum benefit.
For instance, up to $1,000 in student loan interest is deductible on 1998 returns. So if you're below the limit, pay amounts due on the loan by Dec. 31 to make the most of the new deduction.
The Hope Scholarship credit covers the first $2,000 in tuition and fees, while the Lifetime Learning credit (which didn't take effect until midyear) covers the first $5,000. If you're below the limits, you may still have a chance to earn a bigger credit. When computing your 1998 credit, you're allowed to count prepayments of tuition for academic terms that begin in the first three months of 1999. So if by Dec. 31 you mail a check for $1,000 tuition for the winter semester that begins in February, you can use that $1,000 in figuring your 1998 credit.
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